Wholesaling not allowed in California?

Question

Good Morning!

I am a newbie investor and new to the Bigger Pockets community. What a wonderful site!

I have a real estate license and have been in real estate finance for several years, helping others to acquire real estate.

I now want to build my own portfolio of rental properties. I'm planning on starting by wholesaling some properties to build up capital.

Question: I was speaking to a colleague this week about my plan to acquire my first wholesale opportunity, and he told me that he'd found out, through a seminar, that in the state of California, the state frowns on wholesalers, and that if the state finds out that I've completed transactions via transferring title twice in the same day (to two separate entities), too many times, that they will consider me a "dealer" and that I will have to pay 35% tax on any real estate deals I conclude in the state for the rest of my life.  I've never heard that technicality before.

Is there some California code preventing "dealing"  or wholesaling in real estate that I'm not aware of? Maybe I should consult an attorney.

Thanks Bigger Pockets community..

J Scott · Answer

Not to side-track the thread, but in many states, it *IS* illegal in some/all situations for a seller to finance a deal.  This is based on the SAFE ACT laws enacted by the state.

For example, in Georgia, if I buy a house for cash through my business, I can't legally seller finance that house on a sale.  Ridiculous, but true...

Not sure what the SAFE ACT laws in your state are, but your loan officer may very well be correct.

Jon Holdman · Answer

Income from wholesaling isn't short term capital gains.  Its ordinary income, just like fix and flipping.

Phillip Trujillo · Answer

Account Closed So if one is wholesaling in CA, assignment vs. taking title is the way to go to avoid the 3.3% sale price tax imposed by the state?

I'll be moving to northern CA in about 15 months so this is of concern.. Thanks.

Phil

Ellis San Jose · Answer

@Phillip  Trujillo

Yes, there ways to address the 3.3% withholding, I recommend that you read the  statute & get a firm understanding of the exemptions. Then consult with your CPA & attorney to utilize the most appropriate solution for your situation.

Account Closed · Answer

It's a withholding, not a tax.  It's like when your employer withholds from your paycheck and you get it back at the end of the year to the extent it was overpaid.  And it has nothing to do with wholesaling specifically.  Anytime you as an individual, corps and multi-member LLC's are exempt, sell a house in CA, escrow holds back 3.3% of the gross sales price and sends it off to the franchise board if it is an investment property, i.e., it's not your primary residence.  This will explain it better CA 3.3% Withholding.

The problem isn't that you are paying anymore tax than CA's normal extra high rates, it's that it can play havoc with your cash flow if you aren't careful.

Welcome to the land of sunshine! ... And the sun tax that goes along with it :)

Bryan L. · Answer

Constitutional law can't be too terribly difficult judging by the most famous former constitutional law professor in our country.

J Scott · Answer

Absolutely no argument from me that the SAFE ACT is a ridiculous set of laws and at least appears from a layman's perspective to be unconstitutional in some respects (constitutional law is complicated and I'm smart enough to know that I know absolutely nothing about it).  But, the fact is, it exists and even unconstitutional laws can land you fines (or in prison) as long as they're in effect.

Btw, I don't know about other states, but in Georgia, the "police" of the SAFE ACT is the Department of Banking and Finance.  Though, in my experience, even they don't know the law very well.  I called asking about owner financing last year, and the guy had to call me back the next day after doing some research to tell me that it was illegal for my business to owner finance a property but would be legal for me to do it if the property was in my personal name.

Personally, I'd be comfortable seller financing out of my business (even though technically it's illegal), as long as I had a mortgage broker involved to handle the paperwork.  I think the risk of getting caught is small and the buyer would still be protected with the proper disclosures and documentation.

Account Closed · Answer

Dominique: There is a 3.3% of sale price witholding that the state imposes when you sell a property you don't live in here in CA.  If as a wholesaler you take title vs contract assignment this witholding could be more than your wholesale fee.  Maybe this is what your colleague is referring to.  Doesn't sound like it but some times these things get really confused.  Never heard of a 35% tax, that sounds a little too much even for CA.

Bryan L. · Answer

@Jon Holdman  - that's the thing Jon.  According to references cited in Reed's book, there have been cases that have survived an audit and cases that have survived in tax court.  From my understanding of if, there are many issues related to taxes that are somewhat open to interpretation.  I highly recommend Reed's book on the subject.  And I highly recommend a CPA who specializes in Real Estate taxes.

This bears out the real root cause of the issue from the original poster.  People often make statements as matters of fact such as "wholesaling goes on Schedule C", or "wholesaling is subject to self-employment tax", or "wholesaling is not allowed in CA", and people take that are run with it as fact.  It would be better to say that "generally, wholesaling is subject to self-employment tax".  Even so, some people will hear a statement like that and it gets repeated and passed on a few times, and then the next thing you know people are saying things like "the IRS has ruled wholesaling to be illegal", or "wholesaling is not allowed in CA".

Jon Holdman · Answer

@Bryan L. dealer status and the type of income are two different things.  Capital gains tax is on investments.  Investments held under a year, such as a stock you buy and sell in under a year or a rental house that you end up selling in less than a year, are subject short term capital gains tax.  That's the same rate as ordinary income, but is not subject to SET.  OTOH, Goods that are acquired with the intention of selling, like shoes in a shoe store, a house you're rehabbing or a property you buy and sell are inventory.  The profit on those sales is ordinary income subject to both income tax and SET.

As I understand it, "dealer status" mostly affects installment sales.  If the IRS decides you're a dealer you owe tax up front on an installment sale rather than as the money actually comes in.

And dealer status can be property by property.  So, while doing one wholesale deal a year may not make you a dealer that income from the wholesale deal is still ordinary income.  You might get away with calling it a short term capital gain (and avoiding SET), but I don't think that position will survive an audit.

Wholesaling not allowed in California?

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